Strip the Central Bank of Its Power
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Mervyn King, Governor of the Bank of England, complained recently that he lacked the powers required to fulfil his new statutory role of ensuring stability in the banking system. A more powerful Bank of England would do a better job.
He is wrong. The economy would benefit from a weaker Bank of England, stripped of its principal power: namely, the power to set interest rates. This is not intended as a criticism of Mr King or of the other members of his Monetary Policy Committee. No one should be allowed to set interest rates.
Interest rates are simply prices for borrowing. As with all prices, they should be determined by supply and demand in a free market. When they are fixed by a wise man, or by a wise committee, they no longer carry information about the preferences of consumers and the scarcity of resources. On the contrary, no matter how wise the dictator, interest rates set by diktat are sure to be a kind of misinformation, leading those who act on them into error.
To see why, start with the price of something more straightforward. Suppose that global warming changed the popularity of British summer holiday destinations, so that more people wanted to visit Edinburgh and fewer wanted to visit Brighton. Competition for the limited supply of hotel rooms in Edinburgh would bid up their prices, while Brighton hoteliers would have to cut prices to find willing buyers.
Because hotels in Edinburgh would now be more profitable, profit seekers would build new hotels there. Equally, the fall of prices in Brighton would make some hotels there go broke, and the number of rooms would decline. Without anyone planning it, the supply of hotel rooms would adapt to the changing demand for them.
But only with market prices. The process breaks down if prices are set by diktat. Suppose the Bank of England had a Hotel Policy Committee that specified the price of hotel rooms. Then the increasing demand for rooms in Edinburgh would not cause their price to rise. Profit seekers would not get the “price signal” to build more hotel rooms there, and the allocation of resources would not respond to changes in consumer demand.
July 3, 2009
Copyright © 2009 The Times
